Recently, we had the pleasure of visiting with many of our Limited Partners and friends of our firm during our Annual Meeting. To those of you who attended, we thank you. A special thanks to Royce Holland, Executive Chairman of Masergy Communications and Fred Federspiel, President of Pipeline Trading, both of whom presented during the session. Also thanks to Chip Kahn, CEO of IP Commerce, who joined us for our annual family-style dinner.

Given the current macro-economic turmoil, we felt it appropriate to discuss the impact of the credit crisis and equity market dislocation on venture capital investing. This proved to be prescient as the Dow Jones Industrial Average dropped over 1,400 points during the week preceding the Annual Meeting. The question we posed to ourselves was: “What is the impact of the current markets on venture capital?”

The Venture Capital Value Chain
In order to answer that question, one must first understand the key functions of the venture capital business. We believe that Venture Capital investing is comprised of five key functions; Fundraising, Investment Sourcing, Investment Selection, Value Creation and Exiting. In the graphic below, we’ve outlined these functions in a value-chain like construct. We have color-coded the “chevrons”; red signifies a “negative impact”, green signifies a “positive impact”. Full credit to my Partner Jack Tankersley for the construct.

We’ll work our way backwards through the chain.

Exiting – An External Dependency
There can be no doubt that current markets are not exit friendly. I will not be the first, nor the last, to quote the fact that the third quarter of 2008 was the first in 33 where there was not an initial public offering of a venture-backed company. To compound this, with credit markets tightening, strategic buyers are more focused on cost-containment than expansion. Those few strategic buyers which are willing to pursue strategic acquisitions are valuation conscious.

Impact Assessment: Negative

Venture capitalists can (and will) lament the exit markets all day long, but that won’t change the fact that we don’t control them. Only with the long-term view that building a successful company is a five to seven year proposition can one see that today’s exit market is not particularly relevant to the overall process of building value. With that in mind, lets move on the core venture capital functions where a venture capitalist should be able to make an impact.

What We Can Control - Value Creation, Investment Selection and Investment Sourcing
In our nomenclature, Value Creation is the process of working collaboratively with a management team to shape, guide and ultimately, enhance the value of an investment. The value creation process never sleeps; it is not dependent on capital markets. What we have found over the years is that human capital is the fuel that powers the engine of value creation. In difficult macro-economic markets, talent tends to be more available. When the biggest companies in the World are failing or struggling to raise capital, no-one’s job is safe. It may be counter-intuitive, but there is less relative employment risk working for a well-capitalized early stage company in this economic environment.

Regarding Investment Selection, we similarly see some strong positives for firms that have a deep sector orientation and domain expertise. Venture capitalists are expert at pattern recognition. We observe exits, investments by competitors, and news of companies expanding and we assemble this information into a composite view of the investment landscape. But in a slow market, there are fewer external signals to rely on. With fewer external signals, what is required for success is a more fundamental understanding of where value is being created in a sector and a deep level of understanding of the dynamics at work in that sector. This works to the advantage to those among us who have deep sector knowledge.

Finally, regarding Investment Sourcing, I’ll quote Warren Buffett, who in an October, 17 Op-Ed piece in the New York Times, wrote:

“Be fearful when others are greedy and be greedy when others are fearful.”

The third quarter 2008 version of the Silicon Valley Venture Capitalist Confidence Index, performed at the University of San Fancisco’s Entrepreneurship Program, has reached an all-time low. So there is clearly fear in the venture capital community. Anecdotally, what we see is venture capitalists backing away from earlier stage opportunities, dropping venture valuations and stranded companies with fatigued syndicates. But despite the doom and gloom, embedded in the report is a nugget of light:

“While the Index has hit its lowest point to date, this quarter’s respondents had the widest range of confidence since I began this survey nearly 5 years ago with responses ranging from very confident (5) to quite cautious (1).”

This implies a small contrarian view in the venture markets; a Buffetesque view. We share that view. It is a fabulous time to make new venture capital investments.

Impact Assessment: Positive, Positive, Positive

What is required in this investment environment is a long-term view to value creation, an ability to fundamentally identify areas of emerging growth and an ability to build strong syndicates early in a company’s lifecycle to mitigate future capital formation risk. With that view, attractive new investment opportunities abound.

Fundraising – The Other External Dependency
Finally, on to Fundraising. There are two problems plaguing venture capitalists trying to raise new funds in this market. Those of you who are LPs or are venture investor are all too familiar with them. The first is known as the “denominator” problem. At the beginning of every year, most institutional limited partners set a target for their private equity portfolio (including buyout and venture) as a percentage of their total assets under management. For those investors with significant public equity investments in their portfolio, the total value of their portfolio (the denominator) has dropped significantly in value. As a result, many institutional limited partners are “over their limit” in terms of the size of their private equity and venture capital portfolios. The second problem has to do with liquidity. Most institutional limited partners rely on distributions from their private equity fund managers to fund new private equity commitments. With the slowdown in the leveraged buyout market in particular, many institutional limited partners are reporting private equity distributions of only 25 – 33% of what they modeled at the beginning of the year. The last thing an institutional investor wants to do is sell public equity securities at down valuations to fund private equity commitments.

Impact Assessment: Negative

The denominator and liquidity challenges facing institutional LPs make this a very difficult market for venture capital fund formation.

Putting it all together, what does it mean?

In the end, venture capital is and always has been about creating long-term value in a portfolio. For the things we can control - Value Creation, Investment Selection and Investment Sourcing - now is a great time to be a sector focused venture investor and to be an entrepreneur. Fundraising and exit markets are cyclical; they will come and go. But as The Great One, Wayne Gretzky once said:

“I skate to where the puck is going to be, not to where it has been.”

The puck that our most recent investments are skating to is the exit market in five to seven years. There is no telling where the market will be at that time. But it is more likely than not to be more exit-friendly than the market today.